The Chinese liquidity trap

It is not just in developed markets that corporates are finding little productive use for easy money. Monetary easing in China, too, is having little apparent impact on the real economy.

02/09/2016

Craig Botham

Emerging Markets Economist

30 MinutesUnstructured Learning Time

The M1-M21 gap in China, shown in the chart below, has historically functioned well as an indicator of GDP growth. Typically, if M1 growth exceeds M2 growth, it signals that corporates are building cash to invest in capital expenditure and other real economy projects.

However, the gap in China has skyrocketed in the last year with little to show by way of real GDP growth. What is going on?

Chart 1: M1-M2 gap has lost predictive power

Source: Thomson Datastream, Schroders Economics Group. 31 August 2016

A paper from the IMF notes that many Chinese firms facing overcapacity in industries such as mining are under increasing pressure to generate profit to repay loans, even as revenues are falling.

Consequently, although regulations forbid firms using bank loans to invest in the stockmarket, monitoring is difficult and some companies have been tempted into equities.

Other avenues are also available, and some evidence of this redirection of central bank liquidity can be found in the equity, property and commodity futures markets in China, all of which have displayed typical asset bubble behaviour in the last 18 months.

Research also suggests that corporate treasuries have been highly active in the shadow banking world, with state-owned enterprises (SOEs) particularly boosting their involvement in entrusted loan lending.

These loans are intra-corporate lending facilitated by commercial banks, whereby the corporate invests in an asset management product provided by a brokerage asset management firm.

The funds are then lent to other corporates. One research provider, PRC Macro, estimates that RMB 9 trillion, of a total of RMB 12 trillion in entrusted loans, is funded by corporates in this way.

This explains the reluctance of the People’s Bank of China (PBoC) to engage in further monetary easing, particularly cuts in the reserve requirement ratio (RRR)2. There must be a concern, with corporate deposits this high, that the temptation to move money out of the country in search of returns will be strong.

RRR cuts and other permanent liquidity increases at this point increase the potential pressure on the currency.

Certainly, when we look at the M1-M2 gap versus the Chinese yuan/US dollar exchange rate, this fear seems warranted. (We would note, as ever, that correlation does not imply causation, and that sometimes the causation could run the other way. For example, the PBoC may boost liquidity after large foreign exchange outflows).

Chart 2: Boosting liquidity correlates with a weaker currency

Source: Thomson Datastream, Schroders Economics Group. 31 August 2016

There is still pressure from other state bodies for monetary easing, and ultimately we think the PBoC will be forced to acquiesce.

However, there is a growing likelihood that the central bank will seek methods other than the brute force of a RRR cut, and instead look to target liquidity at specific parts of the economy.

This could be done through judicious use of collateral requirements for its open market operations, expansion of the standing lending facility (which channels liquidity to policy banks), or operations similar to the European Central Bank’s Long-Term Refinancing Operation (LTRO) to bring down longer-term yields without further easing short-term borrowing costs.

1. M1 and M2 are different measures of money supply. M1, also called narrow money, normally includes coins and notes in circulation and other money equivalents that are easily convertible into cash. M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds.↩

1. A central bank regulation employed that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).↩

Chinese GDP came in below market expectations, but in line with our forecast, at 6.8% year on year in the final quarter of 2015. This brings 2015 growth to 6.9%, in line with the official target of “around 7% growth”, but highlights the challenges faced by the authorities in propping up growth.

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